- Recent improvements in the funded status of many corporate defined benefit plans have accelerated interest in liability-driven investing (LDI) and led many sponsors to more clearly articulate their LDI objectives. However, the fixed income benchmarks typically used to measure the performance of LDI strategies can be improved.
- T. Rowe Price has developed a methodology for constructing custom LDI benchmarks at the most granular level—from the individual cash flows, both principal and coupon, derived from a given fixed income opportunity set.
- Sponsors may be able to better monitor and attribute changes in pension risk transfer costs using a custom benchmark that has the same cash flow, duration, convexity, yield, and maturity characteristics as their liability as it would be valued by an insurance company.
THE NEXT STEP IN LDI EVOLUTION
As corporate defined benefit plans increasingly have shifted their focus to portfolio de-risking, many have sought fixed income benchmarks that are better aligned with the specific objectives they hope to achieve through liability-driven investing (LDI).
Some sponsors have shifted to longer-duration measures, such as the Barclays Long Credit Index or Barclays Long Government/Credit Index, while others have adopted compound benchmarks or duration-targeted indexes.
T. Rowe Price believes an even higher level of customization is both necessary and feasible. Accordingly, we have developed a methodology for constructing custom fixed income benchmarks at the most granular level possible—the individual cash flows, both principal and coupon, derived from a given fixed income opportunity set.
Based on the bonds in the relevant opportunity set, we create a benchmark that matches, as precisely as possible, a plan’s projected liability cash flows. To ensure continuous liability matching, this investible benchmark is then reset each year to reflect the plan’s actuarial experience, new pension cash flow accruals, and bond market developments.1
SPONSOR OBJECTIVE: MINIMIZE THE VOLATILITY AND OVERALL LEVEL OF INSURANCE RISK TRANSFER COSTS
To highlight the potential benefits of T. Rowe Price’s LDI customization process, we have created a benchmark for the hypothetical plan liability structure shown in Figure 1 (below, right). We assume the sponsor’s LDI objective is to minimize the volatility and overall level of insurance risk transfer costs, which a has two components: reducing portfolio tracking error relative to liabilities and ensuring the portfolio is attractive to insurance companies, allowing an in-kind asset transfer. In our view, creating a benchmark that reflects these considerations might be appropriate for plan sponsors who are considering:
- terminating the entire plan within some defined period,
- transferring a portion of the plan’s liabilities to an insurance company via a group annuity contract (buyout),
- purchasing annuity coverage that matches some segment of the plan’s liabilities (buy-in).
Given the insurance company preferences for in-kind asset transfers, the most appropriate opportunity set for such an investor would be a fixed rate Gov/Corporate universe consisting of U.S. Treasury obligations as well as investment grade (IG) corporate bonds. This universe has a sufficiently high average quality relative to insurer discount rates and satisfies insurance companies’ preferences for in-kind transfers. Based on our conversations with insurance companies, sponsors who prepare their portfolios for an in-kind transfer receive better overall pricing because the insurer doesn’t incur transactional costs on the deal.
The sponsor’s strategic objective would be to minimize portfolio tracking error relative to the benchmark—and thus to the returns on the liability as measured by insurance companies. Our hypothetical custom benchmark (Figure 1B) is designed to provide a much more precise match of the liability structure than would be possible using a standard market-weighted index, such as the Barclays Long Credit Index (Figure 1A). The 10 largest non-Treasury issues in the custom benchmark are shown in Figure 2. Because Treasuries are highly liquid and present minimal default risk, taking large positions in specific issues does not raise the same concentration concerns as it would in an investment grade corporate issue.
Custom LDI Benchmarks Can Provide More Precise Matching of Plan Liability Cash Flows
Hypothetical Plan Cash Flows Valued Using ASC Discount Rates
Data as of 30 Sept 2015
Sources: Barclays, T. Rowe Price; data analysis by T. Rowe Price.
Ten Largest Issues non-Treasury in a Hypothetical Insurance Risk Transfer Custom Benchmark2
As of 30 Sept 2015
|CSX 3.95 '50|
|Mayo Clinic 4.00 '47|
|Northwestern 3.87 '48|
|Ford 7.40 '46|
|Verizon 4.52 '48|
|Sloan-Kettering 4.13 '52|
|Johns Hopkins 4.08 '53|
|Ascension Health 4.85 '53|
|Stanford 3.46 '47|
|Oglethorpe Power 5.25 '50|
Source: T. Rowe Price.
Aligning portfolio construction with insurance company asset standards for in-kind transfer is particularly important, given that many insurers may provide lower rate quotes due to the desirability of the assets they would assume. In order to facilitate an in-kind risk-transfer, the proposed custom benchmark meets insurer preferences for credit quality and sector allocations, as shown in Figure 3 (below). By constructing portfolios in this manner, sponsors can potentially limit the volatility and overall level of the final costs of a risk transfer.
Sector and Quality Breakdown for Hypothetical Insurance Risk Transfer Custom Benchmark
As of 30 Sept 2015
|Quality Breakdown||Benchmark Weight|
|Sector Breakdown||Benchmark Weight|
Source: T. Rowe Price.
Appendix: Constructing Custom LDI Benchmarks
T. Rowe Price has developed its own custom LDI benchmark methodology, which we believe has the potential to:
- reduce liability tracking error compared with market cap-weighted benchmarks and composites,
- allow managers to tailor their investment process more closely to sponsor objectives in terms of spread, duration, and curve sensitivities,
- demonstrate their performance relative to plan liabilities more precisely.
STEP ONE: DEFINE THE OPPORTUNITY SET BASED ON THE SPONSOR'S LDI OBJECTIVES
Hedging asset performance should be monitored as closely as possible against the liability measurement most meaningful to the sponsor. Because different regulatory and accounting regimes use different discount rates, the optimal opportunity set will depend on the sponsor’s de-risking priorities.
STEP TWO: CONSTRUCT A YIELD CURVE
Once the relevant fixed income opportunity set has been defined, bonds are broken down into their discrete coupon and maturity cash flows. In essence, this procedure treats every cash flow as if it were a separate zero-coupon bond, then uses those flows to construct a zero-coupon yield curve that can be matched against the plan’s cash flows.
STEP THREE: ESTIMATE THE PRESENT VALUE OF LIABILITIES
Discounting plan cash flows using the model curve provides the yields needed to determine the plan’s interest rate sensitivity at each point on the curve. The curve is stressed by incrementally increasing and decreasing the yields at each point in order to determine key rate durations (KRD).
STEP FOUR: OPTIMIZE THE BENCHMARK
Asset cash flows are matched to liability KRDs, taking into account how much impact each point on the curve has on the overall present value of plan liabilities. The result is a customized benchmark in which asset and liability weights are matched relatively precisely, especially in the most interest rate sensitive portion of the curve.
With the structure in place, the mandate to the asset manager becomes relatively straightforward: either replicate or outperform the liability-matching cash flow benchmark, while also matching spread and curve sensitivities as closely as possible using instruments that are actively traded and have a reasonable degree of market liquidity.
1For a fuller description of T. Rowe Price’s methodology, please see the Appendix.
2Please refer to the disclosures at the end of this material for important additional information.
This material is directed at institutional investors only and has been prepared by T. Rowe Price Associates, Inc. for informational purposes. This information is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of July 2014 and are subject to change without notice.
The information presented has been developed internally and/or obtained from sources believed to be reliable; however, T. Rowe Price does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained herein may no longer be true after the date indicated. Any forwardlooking statements speak only as of the date indicated and T. Rowe Price assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forwardlooking statements.
Each of the hypothetical plan(s) and custom benchmark(s)/sample strategy presented reflects a model and is not indicative of an actual plan or benchmark or attendant characteristics. The hypothetical plan is representative of an annuity based defined benefit pension plan. The hypothetical custom benchmark(s)/sample strategy is based on the applicable bond universe for the relevant liability measure. Certain of the assumptions have been made for modelling purposes and are unlikely to be realized. The hypothetical plan, and thus the custom benchmark as well, have been created for modelling purposes with the benefit of hindsight. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in creating the hypothetical plan and custom benchmark have been stated or fully considered.
Changes in the assumptions may have a material impact on the hypothetical returns presented. The construction of the plan and benchmark in this manner has certain inherent limitations and may not reflect the impact that material economic and market factors may have had on the custom benchmark construction if an actual plan had existed during the time period presented. Actual tracking of T. Rowe Price’s custom benchmark of any particular plan, including (among other things) yield, annualized return, liability-relative tracking error and average monthly return may differ substantially from the hypothetical scenario presented herein. The specific issues referenced herein should not be viewed as recommendations and it should not be assumed that any investment in the securities identified was, will or would be profitable.
The information presented is supplemental information for GIPS purposes; however, because T. Rowe Price does not currently manage any accounts the strategy presented, a GIPS-compliant presentation is not available. A complete list and description of the firm’s composites is available upon request.
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